Entrepreneurs and Last Week’s Fiscal Deal

Unless you completely unplugged over the holidays, you know that if Democratic and Republican lawmakers could not bridge their differences on how best to reduce the nation's budget deficit and debt, the Budget Control Act of 2011 mandated a combination of spending cuts and tax increases to take effect January 1, 2013. While Washington kicked the can down the road on budget cuts, the cliff was avoided – but what does the deal mean for American entrepreneurs?

There is no doubt that we need to address the $1 trillion-plus annual budget gap. The deadlock was over the solution formula and the relative weight that higher taxes and reduced government spending have in it. This default solution was called the “fiscal cliff” because more than a half-trillion dollars in automatic tax increases and spending cuts would automatically kick-in and studies suggested this default solution would have sent the country back to recession and to higher unemployment. Sales of small businesses already rose in 2012 driven by concerns over the looming fiscal cliff, according to a recent survey by BizBuySell. So clearly, if we avoided a self-inflicted path to recession, despite worries extending beyond the tax code to overall uncertainty, what happened on January 1 was at least in part good for entrepreneurs.

While it is still too early to gauge the effects of the fiscal deal, there are some aspects that are very likely to have an effect on startup creation and growth. First, let’s look at the deal’s effect on consumer demand, which is probably the most immediate concern for businesses. The fiscal cliff would have caused paycheck deductions, increased income taxes, and layoffs and furloughs for federal employees and government suppliers and contractors, all of which would have reduced the cash consumers have for spending. The fiscal cliff deal delayed the solution on the government spending cuts for another two months and I predict with a new Congress, America will have an even harder time disciplining its spending than last year. However, while businesses with government contracts or related operations will not see effects yet, when they come it will be far from insignificant given that in the last decade, according to Dane Stangler of the Kauffman Foundation, government services dominated the Inc. Magazine’s annual list of the fastest-growing companies.

In terms of income taxes, the January 1 deal needs closer attention. Yes, tax increases are limited to a relatively high-income threshold ($450,000 for a couple), so the effect is less shocking than without a deal. However, I would be interested in a closer examination of how many startups file their business operations as “single member LLCs” meaning that as “disregarded entities” for tax purposes, under IRS reporting rules, report all items of income and expenses on the individual tax return of the sole member. Small businesses filing as such would see increased tax rates. Further, the new rate is really now 43.4% not the 39.6% during the Clinton era courtesy of the new 3.8% health care tax.

Beyond income tax rates, most Americans will face increased payroll taxes. Under the deal, a payroll tax holiday set in 2011 to encourage people to spend has been allowed to expire. This increases the employee portion of Social Security contributions from the 4.2 percent to their original rate of 6.2 percent rate. This could hurt spending and sole proprietors.

For investors, the deal increased the top capital gains and dividend tax rates from 15 percent to 23.8 percent (20 percent + 3.8 percent health care surtax). For serial entrepreneurs or entrepreneurs-turned angel investors, this increase means they will pocket less. In general, business angels and venture capitalists will likely contribute less to the pool of capital for high-potential start-ups because their after-tax returns will take a hit and because higher capital-gains taxes simply make investing in startups less attractive. There are high risks already involved in startup investment. Higher taxes on capital gains will inevitably raise the cost of capital for entrepreneurs, hindering business formation and expansion.

In the upcoming debate on spending cuts, policymakers have another chance to demonstrate they care about innovation and entrepreneurship. As Stangler pointed out, history shows that government spending, whether it was through contracts or through research grants, has played a very important role in innovation and economic growth. For example, scientific research & development (R&D) should not stand to lose in the fiscal diet. I am not saying the system governing this area of public investment cannot be more efficient, but rather that it should be done carefully if that is the intention because government-funded R&D has been a great source for technological innovations that were later commercialized, including the Internet. If the link between R&D and startup creation is strengthened, more benefits could be drawn from this government investment.

There were and will continue to be difficult trade-offs in the process of reaching a new framework for fiscal health. Ultimately, we will all bear part of the burden of getting our fiscal situation back to health. But our losses would be tragic if they weaken our entrepreneurial ecosystem that delivers the initiators, the doers and makers of things.

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